Dodd-Frank Clawback Proposal

Written By Brad Smith

The Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted in 2010 and was intended to address shareholder rights and executive compensation practices. The Securities and Exchange Commission was directed, as part of the Dodd-Frank Act, to put in place a requirement that public companies include a clawback provision in their executive compensation contracts that is triggered by any accounting restatement. A clawback provision generally allows companies to recoup erroneously awarded incentive compensation, where an error was detected after issuance of the incentives.

On July 1, 2015, some five years after Dodd-Frank took effect, the Exchange issued a proposed rule to establish the requirements for a clawback provision. The Exchange is accepting comments on the proposal for sixty days.

There are currently no regulations in place requiring a clawback provision. That said, stemming from the Sarbanes-Oxley Act of 2002 (SOX) public and many non-public companies have instituted some form of a clawback provision. SOX requires the Exchange to pursue repayment of incentive compensation from executives that received incentive compensation as a result of fraud.

The Dodd-Frank clawback proposal released by the Exchange would be different from SOX in that it would require:

  • A current or former executive who received all or part of his/her incentive compensation based on erroneous financial statements to return the excess received, regardless of whether the restatement is due to fraud.
  • Recovery from any executive who performs policy-making decisions and received incentive compensation (SOX applies only to the CEO and CFO).
  • Recovery of excess compensation during the three fiscal years prior to the date of the restatement (SOX only reaches back one year).
  • Virtually all companies subject to listing standards of the national securities exchange’s (Exchanges) to adopt a (or revise an existing) clawback policy which meets the minimum requirements of the rule. The provision applies to all public companies regardless of their size.

Issuers and securities subject to the rule

All companies subject to the Exchange’s listing standards will be mandated to have a clawback policy meeting the minimum standards set forth in this rule, with the exception of security futures products, standardized options and the securities of certain registered investment companies.

Restatement necessary to trigger clawback

A clawback will be triggered when a company requires an adjustment to its financial statements and provides incentive compensation which would have been different had the accounting been done properly when the incentive award amount was calculated. Restatements which would not require a clawback include: 

  • Retrospective application of a change in accounting principle
  • Retrospective revision to reportable segment information due to a change in the structure of the issuer’s internal organization
  • Retrospective reclassification due to a discontinued operation
    • Retrospective application of a change in reporting entity, such as from a reorganization of entities under common control
    • Retrospective adjustment to provisional amounts in connection with prior business combination
    • Retrospective revision for stock splits

Executives subject to the policy

Any executive officer who received incentive-based compensation is subject to the policy. Based on the proposal an executive officer would be the company’s president, principal financial officer, principal accounting officer, and vice-president of the company in charge of a principal business unit, division or function, any other officer who performs a policy-making function or any other person who performs similar policy-making functions.

Incentive plans subject to the policy

As proposed, “incentive-based compensation” would be defined as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure.”   Thus, both cash and equity incentives are subject to clawback.

Recovery of excess compensation

When a financial statement adjustment is required, the amount which should be recovered from the executive is the amount of excess compensation the executive received as a result of the erroneous financial statements.

For compensation based on stock price or total shareholder return, companies may use a reasonable estimate of the effect of the restatement on their stock price. The basis used in calculating the stock price effect of an adjustment to previously issued financial statements would need to be provided to the exchange.

Companies would also have some discretion to decline to recover compensation if the expense of doing so would exceed the amount recovered.

Disclosure requirements

For any excess incentive-based compensation relating to a prior restatement, a company would be required to disclose in its proxy:

  • The date of the restatement along with the aggregate amount of excess incentive-based compensation to be recovered and the remaining amount to be collected.
  • The name of each person subject to recovery who the company decided not to pursue recovery, the amounts due from that person and a brief description of why no recovery was warranted.
  • When excess incentive-based compensation is outstanding for more than 180 days, the name of, and amount due from, each person at the company’s last completed fiscal year.

Each exchange has 90 days to determine its proposed listing rules and those rules must become effective no later than one year following the publication date. Each public company must have a recovery policy in place no later than 60 days after the listing exchange’s rules become effective.

Observations 

  • It seems there could be some differences of opinion of which executives “perform policy-making decisions.”
  • Executives may devote more resources to financial reporting.
  • Some executives may not have had anything to do with the misstatement, but would still be required to pay back incentives which were previously thought to be earned.
  • It will be interesting to see if changes to executive compensation amounts come out of this proposal:

-       Will executives want to shift more of their pay from incentive to salary to reduce the risk of future clawbacks? This would be a reverse from the general movement of the market to more performance-based compensation.

-       Will executives expect a larger amount of pay since their compensation is at risk even after it is paid?

  • When the new rule is adopted, virtually every existing clawback policy will need to be rewritten.

It is expected that this provision will likely be met with less skepticism than other Dodd-Frank Executive Compensation proposals. Many argue that other Dodd-Frank provisions (Pay Ratio and Pay for Performance) single out executive compensation levels. This is a provision that is attempting to correct a previous wrong and recover incentives issued which should not have been based on newly-stated financial statements.

If you have any questions, contact the Findley Davies consultant with whom you normally work, or Brad Smith at 419.327.4414 or This email address is being protected from spambots. You need JavaScript enabled to view it..

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